Understanding How Mutual Funds Work

Mutual funds offer multiple benefits for the savvy investor. However, they are far from a "perfect" investment, so you need to know the fundamentals of mutual funds and how they work in order to make an informed investment decision.

What are mutual funds?

Mutual funds are single shares made up of multiple stocks, bonds and other securities. Mutual fund investors pool their money together, employing a professional firm to manage the day-to-day contents of the fund. A single share represents a comprehensive investment and the expense ratio indicates how much of your investment goes toward fees.

What are some advantages of mutual funds?

Mutual funds offer instant diversification. A single share is composed of many other investments, spreading out your portfolio. In addition, you get a professional, seasoned investor picking the contents of the fund. You probably don't have the time to manage your investments each day, so a mutual fund is a great way to get a professional on your side without breaking the bank.

What are some disadvantages of mutual funds?

Mutual funds often have a high threshold for an initial investment. You typically need thousands to get into a good fund. In addition, the distributions on the fund don't add to your net position but require you to pay the tax obligations of the fund. When a fund realizes capital gains, the taxes are covered by the shareholders.

What are some different types of mutual funds?

Some mutual funds hone in on specific sectors or securities. Some popular funds include money market funds, which are short-term investments like treasury bills. These are a safe place to put your money, but you won't get great returns on your investments. Bond and income funds provide steady income through bond positions in government and corporate debt. Balanced funds give you a mix of safety and capital appreciation. Equity funds invest in stocks and try to realize big returns. Global funds focus on the worldwide markets. Specialty funds target sectors or regions. Index funds replicate the performance of broad markets, such as the Standard & Poor's 500 index or the Dow Jones industrial average.

Mutual funds offer you a quick and easy way to diversify your portfolio and put your hard-earned money in the hands of a seasoned investor. The initial investment is a challenge, and keep in mind you are on the hook for any tax obligations of the fund.

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